Financial Liberalisation and Economic Development

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1.1. Introduction

This paper examines the effect of financial liberalisation (FL) on economic development in less developed countries (LDC). The paper is divided into several sections; the first examines the concept of financial repression and the second introduces the Mckinnon-Shaw thesis of financial liberalisation; section three looks at the critique of Mckinnon-Shaw thesis. This paper presents some evidence that will indicate a positive relationship between financial liberalisation and economic development (e.g. growth rate). However, this relationship is not robust. In other words, there are still controversies over the affects of financial liberalisation in LDC’s. Also, this paper will look at the experiences in financial liberalisation in Indonesia.

2.1. Financial repression

For many years, governments across the globe followed a policy of financial repression. Financial repression comes in many forms. Under financial repression nominal interest rates are set below market level, there is control of credit allocation, high reserves requirements and financial system is highly regulated and controlled. The rational for financial repression originates from Keynesian economics and Tobin’s portfolio allocation model.

The Keynesian model states that savings (S) and investment (I) are equal. Keynes assumed that interest rates are determined in the money market. In his model consumption function is an important element. Furthermore, Keynes argues that investment is autonomous, while the level of savings varies with income. Keynesian theory promotes government involvement in the market. The rational for financial repression rises from the Keynesian assumption that a low level of interest rate stimulates the level of investment and increased investment will increase income and hence savings. It is assumed that a rise of income level will increase aggregate demand and that will increase the level of output. Thus, by boosting investment and output there will be an increase in growth.

The rational for financial repression also originates from Tobin’s allocation model. In Tobin’s model of money and growth, economic agents choose between money and productive capital. Here money and productive capital are substitutes. In this model the rate of economic growth will accelerate when yield on money falls. Yield on money falls if there is a reduction in deposit rates of interest or by increasing the inflation rate. Also, if yield on money falls and return on capital rises, economic agents will increase the ratio of capital in their portfolios. Consequently, there will be a higher capital/labour ratio, higher labour productivity and a greater per capita income.

However, the main reason behind financial repression is its fiscal implication. When interest rates are kept below market levels and when banks and financial institutions are forced to hold government securities up to a certain per cent of their total liabilities, governments are able to reduce the costs of public debt. Also, through control of credit allocation, authorities are able to direct credit to priority sectors (for example towards agriculture).

The economic distortions due to policies of financial repression were serious. One of many consequences of financial repression is the reduction of the overall availability of loanable funds to investors. Furthermore, the financial repression retards savings, lowers investment quality and hence growth (Mckinnon and Shaw). The figure 2.1. shows that in the market, which is influenced by policies of financial repression, real interest rates are set below the free market equilibrium real rate, r*. Consequently, there will be reduced amount of investment (if the interest rate is given by r’, the amount of investment will be Ia), due to limited saving.

Real interest rate SY0
SY1
SY2

r*
r’’
r’...
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